Chapter 4

Cash Flow and Financial Planning

„ Instructor’s Resources
Chapter Overview
This chapter introduces the financial-planning process, starting with an overview of long-term or strategic
planning and moving to a detailed exploration of short-term (operating) financial planning and its two key
components: cash and profit planning. Cash planning involves preparation of a cash budget, while profit
planning involves preparation of a pro forma income statement and balance sheet. Step-by-step examples of
cash budget and pro forma statement development are used to illustrate nuances students might find
challenging—such as depreciation expenses as a cash inflow and the distinction between operating and free
cash flow. The chapter ends by highlighting weaknesses of the simplified approaches to pro forma statements
(judgmental and percent-of-sales methods)—while still emphasizing the importance of these statements
(along with the cash budget) as tools for disciplining management thinking about the range of possible cash
flow and profitability outcomes and responses to those outcomes.

„ Suggested Answer to Opener-in-Review

Rapidly expanding firms—like Netflix—often must make significant investments in inventory, receivables,
and fixed assets to sustain their growth. And the related cash outlays will not always appear immediately in
calculation of profit. For example, purchase of a new capital equipment for $1 million dollars requires an
outlay of $1 million dollars now, but that equipment may be expensed piecemeal through depreciation over
several years (although under the Tax Cuts and Jobs Act of 2017, firms are allowed to fully expense many
capital investments). Although not so much the case for Netflix, growing firms may also need to offer
generous credit terms to attract customers from rivals. Sales on credit are typically recognized in the current
year’s profit/loss calculation, even though full payment of the outstanding balance may take years.
Accordingly, a firm could post enviable profits, yet at the same time, lack the cash flow to meet ongoing
obligations without external finance.

„ Answers to Review Questions

4-1. The financial-planning process is a two-step, highly collaborative endeavor to track the financial
implications of the firm’s specific plan for creating value for shareholders. Step one is long-term or
strategic planning, which involves detailing firm financial initiatives and the expected consequences of
those initiatives over a two-to-ten-year horizon. Step two is developing a short-term (operating)
financial plan, consistent with the strategic plan, that lays out the firm’s financial actions and likely
results over a one-to-two-year period.

4-2 The three key outputs of the short-term (operating) financial planning process are the (i) cash budget,
(ii) pro forma income statement, and (iii) pro forma balance sheet.

4-3 Property classes under the Modified Accelerated Cost Recovery System (MACRS) are categorized by
the length of the depreciation (recovery) period. The first four classes are 3-, 5-, 7-, and 10-years:

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Recovery Period Definition

3 years Research and experiment equipment and certain special tools
5 years Computers, printers, copiers, duplicating equipment, cars, light-
duty trucks, qualified technological equipment, and similar assets
7 years Office furniture, fixtures, most manufacturing equipment, railroad
track, and single-purpose agricultural and horticultural structures
10 years Equipment used in petroleum refining or in the manufacture of
tobacco products and certain food products

For tax purposes, firms usually depreciate assets in the first four MARCS property classes via the
double-declining-balance method, using a half-year convention (i.e., taking one-half year’s
depreciation in the purchase year) and switching to straight-line depreciation when advantageous.

4-4. Cash flow from operating activities captures cash inflows/outflows related to the firm’s production cycle,
beginning with the purchase of raw materials and ending with the finished product. Expenses related to
this process are considered operating flows. Cash flow from investment activities tracks cash
inflows/outflows from the purchases and sales of fixed assets and equity investments in other firms.
Finally, cash flow from financing activities highlights cash inflows/outflows from transactions related
to debt and equity financing—such as incurrence/repayment of debt, sales/repurchases of stock, and
dividend payments.

4-5. A decrease in the cash balance is a source of cash flow because funds will be used for some other
purpose, such as investment in inventory. Similarly, an increase in the cash balance is a use of cash
flow because the funds, which the firm obtained by some other action such as an asset sale, are now
being held in cash.

4-6. In compiling a cash-flow budget, it is important to recognize depreciation is a noncash expenditure on

the firm’s income statement. Put another way, depreciation expense reduces taxable income but does
not involve an actual cash outlay. [In contrast, there was a cash outlay when the depreciating asset was
purchased.] So depreciation must be added back to net income to find operating cash flows. The same
logic holds for other non-cash deductions from sales revenues in profit/loss calculation.

4-7. The statement of cash flows traces cash inflows/outflows from three different activities:
(1) operating, (2) investing, and (3) financing. Traditionally, cash outflows are shown as negative
numbers and cash inflows as positive numbers.

4-8. Operating cash flow isolates cash inflows/outflows from routine operations. Interest expense and taxes
are excluded to keep the focus on cash flow from firm operations, independent of how the firm finances
or government taxes those operations.

4-9. Operating cash flow is cash flow generated from the firm’s regular production/sales of goods and
services. Free cash flow is the remainder available to providers of debt (creditors) and equity finance
(owners) after the firm has met operating needs and paid for net investment in fixed/and current assets.
Formally, FCF = OCF – Net Fixed Asset Investment (NFAI) – Net Current Assets Investment (NCAI).

4-10. The cash budget is a statement of the firm’s planned cash inflows and outflows. Management uses this
budget to estimate short-term cash needs and identify future periods with likely cash surpluses and
shortages. The sales forecast is key to preparing the cash budget.

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 Chapter 4 Cash Flow and Financial Planning 57

4-11. The basic format of the cash budget appears below.

Jan. Feb. … Nov. Dec.
Total cash receipts $XX $XX $XX $XX
Less: Total cash disbursements XX XX … XX XX
Net cash flow XX XX XX XX
Add: Beginning cash XX XX … XX XX
Ending cash XX XX XX XX
Less: Minimum cash balance XX XX … XX XX
Required total financing $XX
Excess cash balance $XX

The cash budget includes the following:

• Cash receipts: Total cash inflows in a given period (a month in the example above). The most
common receipts are cash sales, collections of accounts receivable, and cash received from
sources other than sales (dividends and interest received, asset sales, etc.).
• Cash disbursements: Total cash outlays in a given period (again, a month above). The most
common disbursements are cash purchases, payments of accounts payable, rent/lease payments,
wages/salaries, tax payments, fixed-asset outlays, interest payments, payments of cash dividends,
principal payments (loans), and repurchases/retirement of stock.
• Net cash flow: Difference between cash receipts and disbursements in a given period (a month
above).
• Ending cash: Sum of beginning cash and net cash flow for a given period (a month above).
• Required total financing: Amount of funds the firm needs if ending cash for the period is less
than the desired minimum cash balance. Any short-term borrowing necessary to plug the gap will
appear on the balance sheet as “notes payable.”
• Excess cash: Amount of surplus funds if the firm’s ending cash exceeds its desired minimum cash
balance. Managers usually invest the surplus in liquid, short-term, interest-paying securities.

4-12. The ending cash balance, along with the required minimum cash balance, indicate whether the firm will
need additional cash or enjoy a surplus for the given period. If the ending cash balance falls short of the
desired minimum cash balance, the firm must borrow short term to plug the gap. If ending cash exceeds
minimum cash, the firm should invest the surplus short term in marketable securities.

4-13. Uncertainty is the result of forecast error. For example, the linchpin of the cash budget is the sales
forecast. No matter how complex the model used—that is, how many company-specific, market-
specific, and macroeconomic variables are employed—the sales forecast is ultimately an extrapolation
based on past relationships. Periodically, unexpected shocks will sever historical links between
company/market/macroeconomic factors and sales, causing actual outcomes to differ significantly from
predictions. One technique for coping with uncertainty is scenario analysis, which involves preparing
different cash budgets for a range of specific sales levels—such as a pessimistic forecast, a most likely
forecast, and an optimistic forecast. A more sophisticated technique is computer simulation, which
involves sampling from a probability distribution for each variable in the sales forecast to produce
thousands of possible sales outcomes. Simulation output can then be used to obtain probability
estimates for various sales levels.

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4-14. Pro forma statements provide the firm with a framework for analyzing future profitability. They depend
on two key inputs: the sales forecast and financial statements from the preceding year. Specifically, the
sales forecast is applied to the latest balance sheet and income statement to obtain projected values for
next period’s balance sheet and income statements.

4-15. In the percent-of-sales method of generating pro forma income statements, the financial manager
estimates dollar values for individual expense items (such as cost of goods sold, operating expenses,
and interest expense) as a fixed percentage of projected sales.

4-16. The percent-of-sales method assumes all costs are variable—a weakness because most firms have some
fixed costs. For firms with significant fixed costs, the percent-of-sales method understates estimated
profit when sales are projected to rise and overstates estimated profit when sales are projected to fall.
An analyst can minimize this problem by dividing the expense portion of the pro forma income
statement into fixed and variable components.

4-17. The judgmental approach to the pro forma balance sheet involves estimation of some balance-sheet
items, with external finance used as a balancing or “plug” factor. This method assumes variables such
as cash, accounts receivable, and inventory can be forced to take certain values, rather than occurring
as a natural product of ongoing firm transactions.

4-18. The “plug” figure in the judgmental approach is the external financing necessary to bring the pro forma
balance sheet into balance. A positive value means the firm must raise funds externally to meet operating
needs—by incurring debt, issuing equity, or reducing dividends. A negative plug figure implies the
firm expects more than sufficient internal finance to support asset growth. Surplus funds can be used to
repay debt, repurchase stock, or increase dividends.

4-19. The simplified approaches to pro forma statements have two weaknesses, each arising from a
problematic assumption—namely, (1) the firm’s past financial condition is an accurate predictor of its
future and (2) the values of certain variables in the statements can be forced to take desired values.

4-20. The financial manager uses pro forma statements to provide a baseline for evaluating ongoing
performance as the year begins. For example, she might perform ratio analysis and prepare source/use
statements. She could also treat the pro forma statements as actual statements to assess various aspects
of firm condition—liquidity, activity, debt, and profitability—and then adjust planned operations to
achieve short-term financial goals.

„ Suggested Answer to Focus on Practice Box:

“Free Cash Flow at LinkedIn”
Free cash flow is often considered a more reliable measure of firm income than reported earnings. In what
ways might corporate accountants change earnings to present a more favorable earnings statement?

There are many ways to boost reported earnings for a given year. For example, a firm could offer
exceedingly generous credit terms near the end of the fiscal year to pump up sales. The firm could also push
some expenditures planned for the last quarter of the year to the next quarter, so the expenses would show up
on next year’s income statement. Although shady, such practices are not illegal. The Focus on Ethics box in
Chapter 3 described how Logitech fraudulently boosted earnings by overstating the value of unsold units of a
disappointing product and understating likely expenses associated with honoring warranties.

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 Chapter 4 Cash Flow and Financial Planning 59

„ Suggested Answer to Focus on Ethics Box:

“Is Excess Cash Always a Good Thing?”
Suppose unexpected events in the market for your product leave you with significant free cash flow. What benchmark
should you use in determining the best (and most ethical) use of those funds?

Managers should invest free cash flow in only those projects likely to earn returns above what firm shareholders
could obtain elsewhere in financial markets by investing in other firms with comparable risk profiles (assuming
shareholders could invest the free cash flow themselves). Otherwise, managers should return the firms to
shareholders, perhaps through a special dividend.

„ Answers to Warm-Up Exercises

E4-1 Depreciation schedule (LG 2)
Answer:
Recovery
Recovery Year by Year Depreciation
1 20% $13,000
2 32% $20,800
3 19% $12,350
4 12% $ 7,800
5 12% $ 7,800
6 5% $ 3,250
Total Depreciation 100% $65,000

E4-2. Cash inflows and outflows (LG 3)

Answer:
a. Marketable securities increased Cash Outflow
b. Land and buildings decreased Cash Inflow
c. Accounts payable increased Cash Inflow
d. Vehicles decreased Cash Inflow
e. Accounts receivable increased Cash Outflow
f. Dividends paid Cash Outflow

E4-3. Operating cash flow (LG 3)

Answer: OCF = [EBIT × (1 − T)] + depreciation, and
EBIT= Sales – Cost of goods sold − Operating expenses − Depreciation. So,
OCF = [($2,500 − $1,800 − $300 −$200 ) × (1 − 0.35)] + $200
OCF = [$200 × (0.65)] + $200 = $330

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E4-4. Free cash flow (LG 3)

Answer: FCF = OCF − Net fixed asset investment (NFAI) − Net current asset investment (NCAI), and
NFAI = Change in net fixed assets + depreciation;
NCAI = Change in current assets − change in (accounts payable + accruals)
NFAI = $300,000 + $200,000 = $500,000
NCAI = $150,000 − $75,000 = $75,000. Hence,
FCF = $700,000 − $500,000 − $75,000 = $125,000

E4-5. Estimating net profits before taxes (LG 5)

Answer: Rimier Corp—Pro Forma Income Statement 2020
Sales revenue $650,000
Less: Cost of goods sold
Fixed cost 250,000
Variable cost (0.35 × sales) 227,500
Gross profits $172,500
Less: Operating expenses
Fixed expense 28,000
Variable expenses (0.075 × sales) 48,750
Operating profits $ 95,750
Less: Interest expense (all fixed) 20,000
Net profits before taxes $ 75,750

„ Solutions to Problems
P4-1 Depreciation (LG 2; Basic)
Depreciation Schedule
Percentages Depreciation
Year Cost (1) from Table 4.2 (2) (3) = [(1) × (2)]
Asset A
Research Equipment
1 $17,000 33% $5,610
2 $17,000 45% $7,650
3 $17,000 15% $2,550
4 $17,000 7% $1,190
Asset B
Duplicating Equipment
1 $45,000 20% $9,000
2 $45,000 32% $14,400
3 $45,000 19% $8,550
4 $45,000 12% $5,400
5 $45,000 12% $5,400
6 $45,000 5% $2,250

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P4-2. Depreciation (LG 2; Basic)

Depreciation Schedule - Cork stopper machine
(2) Table 4.2 Depreciation
Year (1) Cost Percentages (3) = (1) × (2)
1 $10,000 33% $3,300
2 $10,000 45% $4,500
3 $10,000 15% $1,500
4 $10,000 7% $7,000

P4-3. MACRS depreciation expense, taxes, and cash flow (LG 2 and LG 3; Challenge)
a. Depreciation expense = $80,000 × 0.20 = $16,000 (MACRS depreciation percentages can be
found in Table 4.2 in the text.)
b. The tax savings equal the depreciation deduction times the marginal tax rate. For example, if the
firm’s tax rate is 21%, then the tax savings is 0.21 × $16,000 = $3,360.

P4-4 Depreciation and cash flow (LG 2 and LG 3; Intermediate)

a. Operating cash flow (OCF) = [Earnings before interest and taxes × (1 − Tax rate)] + Depreciation
Sales revenue $400,000
Less: Total costs before depreciation, interest, and taxes 290,000
Depreciation expense (0.19 × $180,000) 34,200
Earnings before interest and taxes (EBIT) $ 75,800
So, OCF = [$75,800 × (1 − 0.21)] + $34,200 = $94,082.

Alternatively, using a tax rate of 40%, which does not reflect the changes enacted in the Tax Cuts
and Jobs Act, the OCF would be $79,680.
b. Depreciation expense is an accounting entry to smooth the cost of an asset over time; there is no
cash outlay. So, when a firm deducts depreciation on its income statement, net income will be
less than cash flow. To find cash flow, depreciation must be added back to after-tax earnings.

P4-5 Classifying cash inflows and outflows (LG 3; Basic)

Notes:
(i) Any reduction in an asset is a cash inflow because that cash has been released for another
purpose. Hence, the $300 decline in cash below is an inflow.
(ii) Depreciation does not involve a cash outlay but is deducted from income to obtain profit; it must
be added back to after-tax earnings to determine cash flow (i.e., treated as a cash inflow).

Item Change ($) I/O Item Change ($) I/O

Cash −300 I Accounts receivable +1,700 O
Accounts payable −1,200 O Net profits +900 I
Notes payable +1,500 I Depreciation +1,100 I
Long-term debt +1,000 I Repurchase of stock +900 O
Inventory +200 O Cash dividends +800 O
Fixed assets +400 O Sale of stock +1,000 I

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P4-6. Finding operating and free cash flows (LG 2; Intermediate)

a. Net operating profit after taxes (NOPAT)
= Earnings before interest and taxes (EBIT) × [1 − Tax rate (T)] = $2,700 × (1 − 0.21) = $2,133.
(Or with a 40% tax rate NOPAT would be $1,620.)
b. OCF = NOPAT + Depreciation = $2,133 + $1,600 = $3,733
(Or if the tax rate had been 40%, OCF would be $3,220.)
c. FCF = OCF − Net fixed asset investment (NFAI) − Net current asset investment (NCAI)
NFAI = ∆Net fixed assets + Depreciation = ($14,800 − $15,000) + $1,600 = $1,400
NCAI = ∆Current Assets − ∆Accounts payable − ∆Αccruals)
= ($8,200 − $6,800) − ($1,600 − $1,500) − ($200 − $300) = $1,400. So,
FCF = $3,733 − $1,400 − $1,400 = $933
(Or again, if the tax rate is 40%, FCF becomes $420.)
d. Keith Corporation has positive cash flows from operating activities. Operating cash flow (OCF) is
more than twice NOPAT. FCF is positive, meaning cash flows from operations are adequate to
cover both operating expense plus investment in fixed and current assets.

P4-7. Statement of cash flows (LG 3; Intermediate)

a. The change in stockholders equity of $157 on the balance sheet is entirely traceable to a $157
increase in retained earnings. No other equity accounts changed in 2019. From Tables 4.4, 4.5
and 4.6, the increase in retained earnings may be broken down as follows:
Net profits after taxes $237
Less preferred dividends $10
Less common dividends $70
Net change in retained earnings $157
On the cash-flow statement, the entry for net profits after taxes appears as a positive $237 (cash
inflow) under “cash flow from operations.” The entry common/preferred dividends paid appears
as a negative $80 (cash outflow) under “cash flow from financing.” The net effect of those two
entries is an increase of cash of $157, so including the $157 change in retained earnings
separately in the cash flow statement would be double counting.
Note: In the first-run printing of this book, the change in retained earnings was $100, not $157.
Other aspects of the answer remain the same, namely that the change in stockholder’s equity is
traceable to a change in retained earnings.
b. Other values are possible. For, example, the company could sell new stock for cash payment.

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P4-8 Cash receipts (LG 4; Basic)

April May June July August

Sales (St) $65,000 $60,000 $70,000 $100,000 $100,000
Cash sales (0.50 × St) $32,500 $30,000 $35,000 $50,000 $50,000
Collections:
Lag 1 month (0.25 × St-1) $16,250 $15,000 $17,500 $25,000
Lag 2 months (0.25 × St-2) $16,250 $15,000 $17,500
Total cash receipts $66,250 $ 82,500 $92,500

P4-9. Cash disbursement schedule (LG4; Basic)

February March April May June July
Sales (St) $500,000 $500,000 $560,000 $610,000 $650,000 $650,000
Purchases
(Pt = 0.6 × St+1) $300,000 $336,000 $366,000 $390,000 $390,000
Disbursements
Cash purchases
(0.1 × Pt) 36,600 39,000 39,000
Payments of A/P:
1-month delay
(0.5 × Pt-1) 168,000 183,000 195,000
2-month delay
(0.4 × Pt-2) 120,000 134,400 146,400
Rent payments 8,000 8,000 8,000
Wages & salary
Fixed 6,000 6,000 6,000
Variable
(0.07 × St) 39,200 42,700 45,500
Taxes payments 54,500
Fixed assets outlays 75,000
Interest payments 30,000
Cash dividend payment 12,500
Total cash disbursement
$465,300 $413,100 $524,400

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P4-10. Cash budget (LG 4; Basic)

March April May June July
Sales $50,000 $60,000 $70,000 $80,000 $100,000
Cash sales (0.2 × St)) $10,000 $12,000 $14,000 $16,000 $20,000
Lag 1 month (0.6 × St-1) 36,000 42,000 48,000
Lag 2 months (0.2 × St-2) 10,000 12,000 14,000
Other income 2,000 2,000 2,000
Total cash receipts $62,000 $72,000 $ 84,000
Disbursements
Purchases $50,000 $70,000 $80,000
Rent 3,000 3,000 3,000
Wages & salaries (0.1 × St-1) 6,000 7,000 8,000
Dividends 3,000
Principal & interest 4,000
Purchase of new equipment 6,000
Taxes due 6,000
Total cash disbursements $59,000 $93,000 $97,000

March April May June July

Total cash receipts $62,000 $72,000 $84,000
Total cash disbursements 59,000 93,000 97,000
Net cash flow $ 3,000 ($21,000) ($13,000)
Add: Beginning cash 5,000 8,000 (13,000)
Ending cash $ 8,000 ($13,000) ($26,000)
Minimum cash 5,000 5,000 5,000
Required total financing
(notes payable) 0 $18,000 $31,000
Excess cash balance
(marketable securities) $ 3,000 0 0
The firm should establish a credit line of at least $31,000 but may need to secure three to four
times this amount based on scenario analysis.

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P4-11. Personal finance: Preparation of cash budget (LG 4; Basic)

a. Sam and Suzy Sizeman—Personal Budget
October - December 2020
October November December
Income
Take-home pay $4,900 $4,900 $4,900

Expenses Percent
Housing 30.0% $1,470 $1,470 $1,470
Utilities 5.0% 245 245 245
Food 10.0% 490 490 490
Transportation 7.0% 343 343 343
Medical/Dental 0.5% 25 25 25
Clothing 3.0% 147 147 440
Property taxes 11.5% 564
Appliances 1.0% 49 49 49
Personal care 2.0% 98 98 98
Entertainment 6.0% 294 294 1,500
Savings 7.5% 368 368 368
Other 5.0% 245 245 245
Excess cash 4.5% 221 221 221
Total expenses $3,995 $4,559 $5,494

Cash surplus or (deficit) $ 905 $ 341 $ (594)

Cumulative cash surplus or (deficit) $ 905 $1,246 $ 652

Note: Amounts are rounded.
b. December is a deficit month.
c. The cumulative cash surplus is at the end of December is $652.

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P4-12. Cash budgeting: Advanced (LG 4; Challenge)

a. and b. Xenocore, Inc.($000)
Sept. Oct. Nov. Dec. Jan. Feb. Mar. Apr.
Forecast of Sales (St) $210 $250 $170 $160 $140 $180 $200 $250
Cash sales (0.20 × St) $ 34 $ 32 $ 28 $ 36 $ 40 $ 50
Collections
Lag 1 month (0.40 × St-1) 100 68 64 56 72 80
Lag 2 months (0.40 × St-2) 84 100 68 64 56 72
Other cash receipts 15 27 15 12
Total cash receipts $218 $200 $175 $183 $183 $214
Purchases Forecast (Pt) $120 $150 $140 $100 $ 80 $110 $100 $ 90
Cash purchases (0.10 × Pt) $ 14 $ 10 $ 8 $ 11 $ 10 $ 9
Payments
Lag 1 month (0.50 × Pt-1) 75 70 50 40 55 50
Lag 2 months (0.40 × Pt-2) 48 60 56 40 32 44
Salaries & wages (0.20 × St-1) 50 34 32 28 36 40
Rent 20 20 20 20 20 20
Interest payments 10 10
Principal payments 30
Dividends 20 20
Taxes 80
Purchases of fixed assets 25
Total cash disbursements $207 $219 $196 $139 $153 $303
Net cash flow
(Receipts – disbursements) 11 (19) (21) 44 30 (89)
Add: Beginning cash 22 33 14 (7) 37 67
Ending cash 33 14 (7) 37 67 (22)
Less: Minimum cash balance 15 15 15 15 15 15
Required total financing
(notes payable) 1 22 37
Excess cash balance
(marketable securities) 18 22 52

b. The line of credit should be at least $37,000 to cover the maximum borrowing needs (for April).

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P4-13. Cash flow concepts (LG 4; Basic)

Note to instructor: There are a variety of possible answers to this problem, depending on student
assumptions. The question is designed to provoke discussion of differences among cash flows,
income, and assets.
Cash Pro Forma Pro Forma
Transaction Budget Income Statement Balance Sheet
Cash sale X X X
Credit sale X X X
Accounts receivable are collected X X
Asset with a five-year life is purchased X X
Depreciation is taken X X
Amortization of goodwill is taken X X
Sale of common stock X X
Retirement of outstanding bonds X X
Fire insurance premium is paid
for the next three years X X

P4-14 Cash budget: Scenario analysis (LG 4; Intermediate)

a. Trotter Enterprises, Inc.—Multiple Cash Budgets ($000)
OCTOBER NOVEMBER DECEMBER
Pessi- Most Opti- Pessi- Most Opti- Pessi- Most Opti-
mistic Likely mistic mistic Likely mistic mistic Likely mistic
Total
cash receipts $260 $342 $462 $200 $287 $366 $191 $294 $353
Total cash
disbursements 285 326 421 203 261 313 287 332 315
Net cash flow −25 16 41 (3) 26 53 (96) (38) 38
Add:
Beginning cash (20) (20) (20) (45) (4) 21 (48) 22 74
Ending cash: −45 (4) 21 (48) 22 74 (144) (16) 112
Less minimum 18 18 18 18 18 18 18 18 18
cash balance
Required $ 63 $ 22 $ 66 $ 162 $ 34
total financing
Excess $3 $4 $56 $ 94
cash balance
b. Under the pessimistic scenario, Trotter will need a credit line of at least $162,000 to cover a cash
shortfall of that amount in December. In the most likely scenario, Trotter will need a credit cline
of at least $34,000 to cover a cash shortfall of that magnitude in December. In the optimistic
scenario, Trotter will not have a cash shortfall in the last three months of the calendar year.

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P4-15 Multiple cash budgets: Scenario analysis (LG 5; Intermediate)

a. and b. Brownstein, Inc. Multiple Cash Budgets ($000)
1st Month 2nd Month 3rd Month
Pessi- Most Opti- Pessi- Most Opti- Pessi- Most Opti-
mistic Likely mistic mistic Likely mistic mistic Likely mistic
Sales $ 80 $100 $120 $ 80 $100 $120 $80 $100 $120
Asset sale 8 8 8
Purchases (60) (60) (60) (60) (60) (60) (60) (60) (60)
Wages (14) (15) (16) (14) (15) (16) (14) (15) (16)
Taxes (20) (20) (20)
Purchase of
fixed asset (15) (15) (15)
Net cash flow $(14) $ 5 $ 24 $ (9) $ 10 $ 29 $14 $ 33 $ 52
Add:
Beginning cash 0 0 0 (14) 5 24 (23) 15 53
Ending cash: $(14) $ 5 $ 24 $(23) $ 15 $ 53 $ (9) $ 48 $105
c. Considering the extreme values reflected in the pessimistic and optimistic outcomes allows
Brownstein to plan borrowing or short-term investments carefully. For example, the firm knows
the worst-case scenario is the need for a credit line of at least $23,000 to cover a cash shortfall in
the second month (in the pessimistic scenario).

P4-16 Pro forma income statement (LG 5; Intermediate)

a. Pro Forma Income Statement—Metroline Manufacturing, Inc.
Year Ending December 31, 2020 (Percent-of-Sales Method)
Sales $1,500,000
Less: Cost of goods sold (0.65 × sales) 975,000
Gross profits $ 525,000
Less: Operating expenses (0.086 × sales) 129,000
Operating profits $ 396,000
Less: Interest expense 35,000
Net profits before taxes $ 361,000
Less: Taxes (0.40 × NPBT) 144,400
Net profits after taxes $ 216,600
Less: Cash dividends 70,000
To retained earnings $ 146,600
Note: Operating expense percentage was found by dividing 2019
operating expenses ($) by sales ($), and rounding to third
decimal place.

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c. Pro Forma Income Statement - Metroline Manufacturing, Inc

Year Ending December 31, 2020 (Fixed and Variable Data)
Sales $1,500,000
Less: Cost of goods sold - fixed 210,000
Cost of goods sold - variable (0.5 × sales) 750,000
Gross profits $ 540,000
Less: Fixed expense 36,000
Variable expense (0.06 × sales) 90,000
Operating profits $ 414,000
Less: Interest expense 35,000
Net profits before taxes (NPBT) $ 379,000
Less: Taxes (0.40 × NPBT) 151,600
Net profits after taxes $ 227,400
Less: Cash dividends 70,000
To retained earnings $ 157,400
Note: Variable cost and expense percentages were found by dividing 2019 variable
cost or expense ($) by sales ($) and rounding to third decimal place.
c. When sales are projected to rise, and the firm has fixed costs, pro forma income statements based
on percentages of sales will overstate costs and understate profits. Both conditions are met here,
so a pro forma income statement decomposing fixed and variable cost would be more accurate.

P4-17 Pro forma income statement: Scenario analysis (LG 5; Challenge)

a. Pro Forma Income Statement—Allen Products, LP
Year Ending December 31, 2020
Pessimistic Most Likely Optimistic
Sales $900,000 $1,125,000 $1,280,000
Less cost of goods sold (45% of sales) 405,000 506,250 576,000
Gross profits $495,000 $ 618,750 $ 704,000
Less operating expense (25% of sales) 225,000 281,250 320,000
Operating profits $270,000 $ 337,500 $ 384,000
Less interest expense (3.2% of sales) 28,800 36,000 40,960
Net profit before taxes $241,200 $ 301,500 $ 343,040
Less Taxes (25%) 60,300 75,375 85,760
Net profits after taxes $180,900 $ 226,125 $ 257,280
b. The simple percent-of-sales method assumes all costs/expenses are variable. In the pessimistic
case, this assumption causes all costs/expenses to fall by a given percentage of the decline in sales
from the “most likely” baseline. In reality, however, some costs/expenses are fixed, so total
costs/expenses will not decline as much as projected. In short, the percent-of-sales method
understates costs/expenses and overstates profit relative to the fixed-variable method when sales
are falling. The opposite occurs in the optimistic case—that is, the percent-of-sales method
assumes all costs/expenses rise by a given percentage of sales when in reality only the variable
portion increases. So, when sales rise, percent-of-sates estimates overstate costs/expenses and
understate profits relative to the fixed-variable method,

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c. Pro Forma Income Statement - Allen Products, LP

for the Year Ended December 31, 2016
Pessimistic Most Likely Optimistic
Sales $900,000 $1,125,000 $1,280,000
Less cost of goods sold:
Fixed 250,000 250,000 250,000
a
Variable (18.3%) 164,700 205,875 234,240
Gross profits $485,300 $ 669,125 $ 795,760
Less operating expense
Fixed 180,000 180,000 180,000
Variable (5.8%)b 52,200 65,250 74,240
Operating profits $253,100 $ 423,875 $ 541,520
Less interest expense 30,000 30,000 30,000
Net profit before taxes $223,100 $ 393,875 $ 511,520
Less Taxes (25%) 55,775 98,469 127,880
Net profits after taxes $167,325 $ 295,406 $ 383,640
a
Cost of goods sold variable percentage = ($421,875 − $250,000) / $937,500
b
Operating expense variable percentage = ($234,375 − $180,000) / $937,500
d. Profits for the pessimistic case are larger in (a) than in (c). For the optimistic case, profits are
lower in (a) than in (c). This pattern confirms the relationship stated (b).

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P4-18 Pro forma balance sheet: Basic (LG 5; Intermediate)

a. Pro Forma Balance Sheet—Leonard Industries, as of December 31, 2020

Assets Liabilities & stockholders’ equity
Current assets Current liabilities
Cash $ 50,000 Accounts payable
Marketable securities 15,000 (14% of sales) $ 420,000
Accounts receivable Accruals 60,000
(10% of sales) 300,000 Other current liabilities 30,000
Inventories Total current liabilities $ 510,000
(12% of sales) 360,000 Long-term debts 350,000
Total current assets $725,000
Total liabilities $ 860,000
Net fixed assets1 658,0001
Common stock 200,000
Total assets $1,383,000
Retained earnings 270,0002
Total stockholders’ equity $ 470,000
External funds required3 53,0003
Total liabilities & stockholders’ equity $1,383,000

1
Beginning gross fixed assets $ 600,000
Plus: Fixed asset outlays 90,000
Less: Depreciation expense (32,000)
Ending net fixed assets $ 658,000

2
Beginning retained earnings (1/1/2020) $ 220,000
Plus: Net profit after taxes (4% of $3,000,000) 0.04) 120,000
Less: Dividends paid (70,000)
Ending retained earnings (12/31/2020) $ 270,000
3
Total assets $1,383,000
Less: Total liabilities and equity 1,330,000
External funds required $ 53,000

b. The finance manager should arrange a credit line of at least $53,000. Of course, if financing
cannot be obtained, one or more of the constraints may be changed.
c. If planned 2020 dividends were reduced to $17,000 or less, Leonard would not need additional
financing. Reducing the dividend would allow the firm to retain more cash to cover the growth in
other asset accounts.

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P4-19 Pro forma balance sheet (LG 5; Intermediate)

a. Pro Forma Balance Sheet—Peabody & Peabody (as of December 31, 2021)
Assets
Current assets
Cash $ 480,000
Marketable securities 200,000
Accounts receivable (12% of 2021 sales) 1,440,000
Inventories (18% of 2021 sales) 2,160,000
Total current assets $4,280,000
Net fixed assets1 4,820,000
Total assets $9,100,000

Liabilities and stockholders’ equity

Current liabilities
Accounts payable (14% of 2021 sales) $1,680,000
Accruals 500,000
Other current liabilities 80,000
Total current liabilities $2,260,000
Long-term debts 2,000,000
Total liabilities $4,260,000
Common equity2 4,065,000
External funds required 775,000
Total liabilities and stockholders’ equity $9,100,000
1
Beginning net fixed assets (1/1/2020) $4,000,000
Plus: Fixed asset outlays 1,500,000
Less: Depreciation expense (680,000)
Ending net fixed assets (12/31/2021) $4,820,000

2.
Common equity is the sum of common stock and retained earnings.
Beginning common equity (January 1, 2020) $3,720,000
Plus: Net profits after taxes (2020 = 3% of 2020 sales) 330,000
Net profits after taxes (2020 = 3% of 2021 sales) 360,000
Less: Dividends paid (2020 = 50% of 2020 NPAT) (165,000)
Dividends paid (2021 = 50% of 2020 NPAT) (180,000)
Ending common equity (December 31, 2021) $4,065,000

b. Total assets at year-end 2021 equal $9.1 million while total liabilities and common equity equal
$8.235 million—implying Peabody & Peabody needs additional financing of at least $775,000
over the next two years (to bring the pro forma balance sheet into balance).

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P4-20 Integrative: Pro forma statements (LG 5; Challenge)

a. Pro Forma Income Statement—Red Queen Restaurants
Year Ending December 31, 2020 (Percent-of-Sales Method)
Sales $900,000
Less: Cost of goods sold (0.75 × sales) 675,000
Gross profits $225,000
Less: Operating expenses (0.125 × sales) 112,500
Net profits before taxes $112,500
Less: Taxes (0.21 × NPBT) 23,635
Net profits after taxes $ 88,875
Less: Cash dividends 35,000
To Retained earnings $ 53,875

b. and c. Pro Forma Balance Sheet—Red Queen Restaurants

December 31, 2020 (Judgmental Method)
Assets Liabilities and Equity
Cash $ 30,000 Accounts payable $112,500
Marketable securities 18,000 Taxes payable4 5,906
1
Accounts receivable 162,000 Other current liabilities 5,000
2
Inventories 112,500 Current liabilities $128,750
Current assets $322,500 Long-term debt 200,000
Net fixed assets3 375,000 Common stock 150,000
Retained earnings5 228,875
External funds surplus6 -4,781
Total assets $697,500 Total liabilities & stockholders’ equity $697,500
Notes:
1. Accounts receivable = 0.18 × 2020 sales ($900,000) = $162,000
2. 2019 inventories as a % of 2019 sales is 0.125. 0.125 × 2020 sales ($900,000) = $112,500
3. Net fixed assets (1/1/2020) $350,000
Plus: New machine 42,000
Less: Depreciation (17,000)
Ending net fixed assets (12/31/2020) $375,000
4. Taxes payable = $23,635 × 0.25 = $5,906
5. Beginning retained earnings (1/1/2020) $175,000
Plus: Net profit after taxes 88,875
Less: Dividends paid (35,000)
Ending retained earnings (12/31/2020) $228,875
6. Total assets equal $697,500 while total liabilities and stockholders’ equity equal $702,281.
The difference—the amount needed to balance the pro forma balance sheet is -$4781. Red
Queen will have a funding surplus equal to this amount in 2020.
Note: In the first printing of this book, a tax rate of 40% rather than 21% was used for this
problem. Accordingly, some of the answers above would be different under that tax rate.

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P4-21. Integrative: Pro forma statements (LG 5; Challenge)

a. Pro Forma Income Statement—Provincial Imports, Inc.
Year Ending December 31, 2020 (Fixed and Variable Cost Method)
Sales $6,000,000
Less: Cost of goods sold (0.35 × sales + $1,000,000) 3,100,000
Gross profits $2,900,000
Less: Operating expenses (0.12 × sales + $250,000) 970,000
Operating profits $1,930,000
Less: Interest expense 200,000
Net profits before taxes (NPBT) $1,730,000
Less: Taxes (0.21 × NPBT) 363,300
Net profits after taxes (NPAT) $1,366,700
Less: Cash dividends (0.40 × NPAT) 546,680
To Retained earnings $ 820,020

b. Pro Forma Balance Sheet—Provincial Imports, Inc.

December 31, 2020 (Judgmental Method)
Assets Liabilities and Equity
Cash $ 400,000 Accounts payable $ 840,000
Marketable securities 225,000 Taxes payable 138,0541
Accounts receivable 750,000 Notes payable 200,000
Inventories 1,000,000 Other current liabilities 6,000
Current assets $2,325,000 Current liabilities $1,184,400
2
Net fixed assets 1,646,000 Long-term debt 500,000
Common stock 75,000
Retained earnings 2,195,0203
External funds required 66,926
Total liabilities &
Total assets $4,021,000 stockholders’ equity $4,021,000
1
Taxes payable for 2019 are nearly 38% of the 2019 taxes on the income statement. The pro forma
value is obtained by taking 38% of 2020 taxes (0.38 × $363,300 = $138,054).
2
Net fixed assets (January 1, 2020) $1,400,000
Plus: New computer 356,000
Less: Depreciation (110,000)
Net fixed assets (December 31, 2020) $1,646,000
3
Beginning retained earnings (January 1, 2020) $1,375,000
Plus: Net profit after taxes 1,366,700
Less: Dividends paid (40% of NPAT) (546,680)
Ending retained earnings (December 31, 2020) $2,195,020

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c. Total assets equal $4,021,000, total liabilities equal $1,684,054, and stockholders’ equity equals
$2,270,020. The difference between total assets and total liabilities plus stockholders’ equity—the
amount needed to balance the pro forma balance sheet—is $66,926. Provincial Imports will need
this amount of external financing in 2020.

Note: In the first printing of this book, a tax rate of 40% rather than 21% was used for this
problem. Accordingly, some of the answers above would be different under that tax rate.

P4-22 Ethics problem (LG 3; Intermediate)

Investors welcome increased transparency, accountability, and integrity. Speedy dissemination of
negative information will cause a firm’s stock price to fall sooner than it otherwise would have. But a
consistent policy of releasing negative information quickly (rather than trying to bury it) would signal
the firm’s strong commitment to ethical business practices. And over the long run, investors should
reward the company for its commitment to ethics.

„ Case
Case studies are available on www.pearson.com/mylab/finance.

Preparing Martin Manufacturing’s Pro Forma Financial Statements

In this case, the student will prepare pro forma financial statements and use them to determine whether Martin
Manufacturing will require external funding to embark on a major expansion program.
a. Martin Manufacturing Company—Pro Forma Income Statement (Year Ending 2020)
Sales revenue $6,500,000 (100%)
Less: Cost of goods sold 4,745,000 (0.73 × sales)
Gross profits $1,755,000 (0.27 × sales)
Less: Operating expenses
Selling expense and general
and administrative expense $1,365,000 (0.21 × sales)
Depreciation expense 185,000
Total operating expenses $1,550,000
Operating profits $ 205,000
Less: Interest expense 97,000
Net profits before taxes $ 108,000
Less: Taxes (40%) 43,200
Total profits after taxes $ 64,800

Note: Calculations were “driven” by cost of goods sold and operating expense percentages (excluding
depreciation, which is given).

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b. Martin Manufacturing Company—Pro Forma Balance Sheet (as of December 31, 2020)

Assets
Current assets
Cash $ 25,000
Accounts receivable 890,4111
Inventories 677,8572
Total current assets $1,593,268
Gross fixed assets $2,493,819
Less: Accumulated depreciation 685,000
Net fixed assets $1,808,819
Total assets $3,402,087

Liabilities and stockholders’ equity

Current liabilities
Accounts payable $ 276,000
Notes payable 311,000
Accruals 75,000
Total current liabilities $ 662,000
Long-term debts 1,165,250
Total liabilities $1,827,250
Stockholders’ equity
Preferred stock $ 50,000
Common stock (at par) 400,000
Paid-in capital in excess of par 593,750
Retained earnings 344,8003
Total stockholders’ equity $1,388,550
Total $3,215,800
External funds required 186,287
Total liabilities and stockholders’ equity $3,402,087
1
$6,500,000/365 × 50 days = $890,411
2
Inventory turnover = cost of goods sold / inventory
Inventory = 4,745,000 / 7 = 677,857
3
Beginning retained earnings (January 1, 2020) $300,000
Plus: Net profits 64,800
Less: Dividends paid (20,000)
Ending retained earnings (December 31, 2020) $344,800

c. Based on the pro forma financial statements prepared above, Martin Manufacturing will need to raise
about $200,000 ($186,287) in external financing to undertake its construction program.

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„ Spreadsheet Exercise
Answers to Chapter 4’s ACME Company spreadsheet problem are available on
www.pearson.com/mylab/finance.

„ Group Exercise

Group exercises are available on www.pearson.com/mylab/finance.

This chapter’s exercise focuses on each group’s fictitious firm, with particular attention to asset depreciation
and cash flows. Students are directed to the IRS’s website to retrieve depreciation information from publication
number 946. Using this information, each group will then provide examples of property depreciation for its
firm. Next, students will turn to financial planning –with each group evaluating recent statements of cash
flows for its shadow firms and accounting for any changes. Similar evaluation/analysis should then be
performed on each group’s fictitious firm. Students should also take short- and long-term planning
information from the strategy section of the shadow firm’s annual report and apply it their fictitious firms.
Cash budgeting for the fictitious firm and pro forma statements from the shadow firm conclude the
assignment.

The best advice here is for students to keep it simple. Impress upon them the rapidly increasing complexity of
the budgeting process as the number of accounts is increased. Encourage students to following the text’s
examples and use information from the shadow firm.

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